Gaining perspective on recent active manager equity performance

As we have said before on this blog, active and passive both can have a role to play in helping investors achieve their desired financial outcomes. The key is ensuring that both investment approaches are used insightfully, with sensible expectations around risk and return, and as part of a well-managed portfolio. Sometimes, that’s easier said than done. The challenge often comes in reconciling your experience with your expectations and, particularly with active investing, assessing whether you should stick with it during the “hardest” times to potentially benefit from the more rewarding times. The cyclicality of active management So much of what we see in capital markets is cyclical. The same applies to enthusiasm around active management. When active manager results have a soft patch, the media is awash with obituaries for active investment. When results are stronger, triumphalist investors (maybe even your neighbor?) let everyone know how much money passive investors have left on the table. And so it goes, back and forth. As an aside, for those of us who observe and evaluate investors for a living, many of these analyses can be painfully off-target. They tend to use limited data sets and poorly formed hypotheses to draw overly broad conclusions. A recent example is a New York Times articlewhich found that the fact that no managers were top quartile five years in a row somehow “(supports) the considerable body of evidence suggesting that most people shouldn’t try to beat the market.” However, I would argue that even the most committed proponent of active management would never claim that top quartile performance five years in a row is a sensible ambition, much less an expectation. The last few years have certainly been hard times for active equity investors.  In fact, market results show that the past four years ending December 31, 2014 have been some of the worst since 1999 for those attempting to capture an excess return in equity, and in particular in U.S. Large Cap and Global Equity manager universes. A manager universe is a peer group of investment managers who have the same investment style. Manager universe data is often used for comparisons and evaluating the performance of money managers. We see a few simple reasons for this:
  1. Security selection opportunity has been unusually scarce
  2. Generally speaking, active manager biases were big losers
  3. In most cases, even skill couldn’t bail you out
I will talk about each in turn.

Security selection opportunity is not a constant

The magnitude of opportunity to make money through security selection ebbs and flows over time. One great way to measure the opportunity is by observing the performance gap between higher performing stocks and lower performing stocks. The larger that return difference, the more opportunity for active managers to add value from selecting the better stocks. On the other hand, as the gap shrinks so does that pool of active return opportunities. Using this measure, the data reveals that 2011-2014 has seen the smallest return difference we have seen in the last couple of decades, exceeding the 2003-2006 period in which opportunity was similarly compressed. Given this backdrop, you would expect it to be challenging for stock pickers to make much of an impact. Sources: Global represented by Russell Global Index; U.S. Large Cap respresented by the Russell 1000® Index. Sources: Global represented by Russell Global Index; U.S. Large Cap respresented by the Russell 1000® Index.

Active manager biases were big losers

Over the same 2011-2014 period, active managers faced another challenge as shown in the subsequent charts and narrative: some of the investment positions that were favored by a meaningful portion of active managers in the Russell universes were significant underperformers relative to the broader equity market.

Emerging market equity overweights, U.S. equity underweights

Active manager biases were most evident in global equity, where the longstanding active manager tendencies to overweight emerging market equity and underweight U.S. equity both took a toll on active returns. In fact, Russell’s proprietary database of active manager performance and holdings shows that over the past 12 years as of December 31, 2014, regardless of how well or poorly the U.S. market did relative to the rest of the world, about 75% of global managers were underweight the U.S. relative to the Russell Global Index. A bias of similar magnitude toward an emerging market overweight has also been in evidence among global managers over the past decade. Source: Russell Investments Source: Russell Investments For simplicity’s sake, Russell Indexes are used in the following charts to represent asset class performance. The results below show how much the U.S. (represented by the Russell 1000® Index) outperformed and emerging markets (represented by the Russell Emerging Markets Large Cap Index) underperformed relative to global equity (represented by the Russell Global Index). Given that 75% of active managers held an underweight to the U.S., they missed out on the outperformance of the U.S. This was a significant driver of poor active returns. "U.S. Emerging Markets represented by the Russell Emerging Markets Large Cap Index, compared to Global Equity, represented by the Russell Global Index. U.S. Large Cap represented by the Russell 1000® Index, compared to Global Equity, represented by the Russell Global Index. Overweight U.S. small cap and out of benchmark non-U.S. equity allocations Within U.S. Large Cap, we saw a similar story play out. Within the manager universe, overweights were typically made to smaller cap stocks and out of benchmark (or non-U.S. small cap) allocations to stocks in other developed countries, which contributed to poor active management results in the period 1999-2014. "U.S. U.S. Small Cap represented by the Russell 2000® Index, compared to U.S. Large Cap, represented by the Russell 1000® Index. Developed represented by the Russell Developed Market Equity Index, compared to U.S. Large Cap, represented by the Russell 1000® Index. As it turns out, though, long-term investors can take heart from the fact that, in all cases, the return impacts of these positions over 16 years were negligible, as shown in the right hand set of bar charts above. And over the previous 12 years ending in December 31, 2010, they were all positive (gross of fees). Of course, keep in mind that fees do reduce performance returns and one cannot invest directly in an index.

Even skill couldn’t bail you out

These headwinds have had a substantial impact on the success of the average active manager. But what if you had access to skillful managers who could do better than the average? How much benefit would investors have taken from having exposure to a skillful or “above average” manager? Internal analysis conducted using Russell’s proprietary manager database attempts to measure this skill payoff over different periods. The study simulates how much more excess return an investor could reasonably have expected to get if they constructed portfolios with a greater than average chance of picking outperforming managers. [The study assumed the investor had a 60% chance of picking an above average manager.] This allows you to gauge whether the skill could have reasonably been expected to balance out the headwinds of an otherwise hostile environment. In general, the findings were that the payoff varies widely over different time periods and that the recent past was a low point. First, the good news, though:
  • As shown by the blue bars (representing active manager skill) in the chart below, over the full 16 year period of the study – which included such memorable market periods as the bursting of the IT bubble, the Global Financial Crisis and the recent challenging active management period – investing with skillful managers paid off handsomely, with a median result of over 2.5% in Global equity and nearly 2% in U.S. Large Cap equity annualized. Even discounting the fact that these results are gross of fees (fees do reduce performance returns), this suggests that the payoff for skill in active management is alive and well.
On the negative side:
  • The study found that 2011-2014 was so difficult that even a 60% allocation to above-average active managers was not enough to generate outperformance as compared to the benchmarks used in the study. The results (shown below in the orange bars) shows that neither Global Equity nor U.S. Large Cap Equity manager universes yielded significantly positive returns on this basis, even gross of fees.
Unfortunately, heroic levels of skill (much higher than was built into this study) would have been required to turn the tide. Seen in the context of the longer horizon results, this appears to have been the worst of times, but in our opinion, hardly a permanent state. Global Equity represented by the Russell Global Index. U.S. Large Cap Equity represented by the Russell 1000® Index. Global Equity represented by the Russell Global Index. U.S. Large Cap Equity represented by the Russell 1000® Index.

The bottom line

2011-2014 was undeniably a very challenging period for active equity investing. Security selection opportunity, payoffs for favored positions, and insufficient opportunity for skilled managers all weighed against investors attempting to earn a positive active return. This has led many investors to question the wisdom of choosing active management over passive alternatives. Investors should be aware, though, that none of these conditions are likely permanent (in fact, at Russell we believe that they are all cyclical), and in our opinion none imply any change in the odds of active management success over the long run. Although this fallow period may test your patience, we don’t believe it should shake your faith.